CAN THE RATE OF INTEREST FALL TO ZERO? Economics Assignment Help

CAN THE RATE OF INTEREST FALL TO ZERO?
Theoretically, a zero rate of interest can be conceived. As pointed out above as time goes on, people’s power to save and will to save tend to increase. The former because of the rising productive capacity and the latter because of the greater foresight and the latter because of the greater foresight and the tendency to discount the future at a low rate among the more advanced people. A stage can be imagined in which capital accumulation may outstrip the demand for capital, thus lowering the marginal productivity of capital to zero, even making it negative; that is, people may even pay something for the care of their savings. It is, however, extremely improbable that such a stage will be ever reached. In the first place, the demand for capital will increase with the increase in population and the increase in the variety of people’s wants. Moreover, technical progress, including new inventions and discoveries, is constantly taking place which raises the net productivity of capital and so interest rates. It is true, of course, that new inventions may substitute methods, which economise capital: this may lead to a fall in the rate of interest. But the marginal productivity of capital will still be positive, and, hence there will always be a positive rate of interest. Moreover, the difference between the present gratification and future gratification cannot altogether be removed. The rate of interest is a measure of this difference. Looking from the side of supply also, we come to the same conclusion. Some people may save even if the rate of interest is zero or negative. But the volume of savings would be seriously reduced if there were no compensation for postponing consumption, thus creating relative scarcity of capital. Thus, there is no possibility of the rate of interest falling to zero. We can expect a zero rate of interest only if capital loses its character of scarcity. As it is, capital is scarce relatively to demand for its services. There are so many alternative uses to which capital can be put. It is the rate of interest which determines to what uses may be put. That the zero rate of interest is improbable is also brought out by the Keynesian Theory of Interest, viz., Liquidity Preference Theory. Look at the shape of the Ip curve in Fig. 34.6. It has three distinct parts: the upper reach which is steep, the middle one with a medium.slope and the tail which is a horizontal straight line. The upper portion which is steeply falling indicates that, at a high rate of interest; the demand for money has low interest-elasticity. That is, even if the rate of interest falls, the demand for money to hold does not increase much. But when the rate of interest Interest • 405 is neither very high nor very low (which is shown by the middle part of the curve), then the demand for money is interest-elastic, which means that even With a small fall in the rate of interest, the demand for money is interest-elastic, which means that even with a small fall in the rate of interest, the demand for money will increase considerably. But when you come to the flat portion, i.e., the tail of the curve, the demand for money is infinitely elastic. In other words, the demand for money is perfectly elastic in respect of interest rate and as.the liquidity preference reaches its maximum, i.e., at the very low rate of interest, there. is no limit to the amount of money which the people would like to hold. This is a position of Absolute liquidity Preference. It is also called Liquidity Trap by some economists. Now, suppose that the position of liquidity trap or absolute liquidity preference is reached at 2 per cent rate of interest shown by that portion of the Ip curve which is a horizontal straight line. All increase of money now will be absorbed by the people and it will not lower the rate of interest. They will not now Ii e to invest any portion of their money in bonds. The reason is that they do not expect the rate of interest to fall further to the price of bonds to rise. Since the price of bonds is not expected to rise, why should they take the risk of investing money in them? That is, they will like to keep the entire stock of money with themselves. In other words, at this stage no amount of increase in the money supply will lead to a reduction in the rate of interest. Thus, from this characteristic of liquidity preference (being perfectly elastic in respect of low rate of interest) an important conclusion can be drawn, that the rate of interest is not likely to fall below a certain low figure. There is no way of depressing the rate of interest further even though such fall may be in public interest. In other words, an important implication of perfect elasticity of liquidity preference at a certain low rate of interest is that the rate of interest cannot fall to zero. Conclusion

We may conclude in Samuelson’s words, “As long as any increase in time-consuming process could be counted on to produce any extra product and dollars of revenue, the yield of capital could not be zero. Also, as long as any land or other asset exists with a sure perpetual net income -and as long as people are willing to give only a finite amount of money today in exchange for a perpetual flow of income spread over the whole future-then we can hardly conceive of the rate of interest as falling to zero.” 12